After years of feeling like they’ve overpaid for a European hotel room, US vacationers can finally enjoy trips abroad at a much more favorable exchange rate. They have the Federal Reserve to thank. While the Fed’s interest rate hikes have stressed domestic stock and bond markets, the US dollar has been a prime beneficiary.
But is the strengthening dollar likely to persist—or should we expect a reversal in the near future? It’s one of the key questions for the global economy and markets but requires a bit more digging to answer. Let’s start with the broader picture surrounding the US dollar’s climb.
Why Is the Dollar So Strong?
Of late, the dollar has been supported by a few key factors:
- The Fed winning the footrace to raise rates: Differences in countries’ monetary policies have helped fuel the dollar’s appreciation. The gap between nominal interest rates has widened as the Fed has raised rates more quickly than many foreign central banks, especially those in developed economies. Higher US interest rates make US bonds (which investors purchase with US dollars) more attractive, driving increased demand for the currency.
- Best house in the worst neighborhood: Having snapped back smartly after the initial phase of the pandemic, the US’s growth outlook continues to compare favorably to other developed economies. More recently, Europe has been affected by reduced exports of Russian natural gas and rising energy costs, dampening activity and likely leading to a recession.
- Alarm bells spur dollar buys: The dollar has continued to benefit from its enduring safe-haven status. As higher interest rates sow doubts about global growth prospects, capital flocks to the dollar as the world’s reserve currency.
What’s the Impact?
US dollar appreciation matters for more than just vacations. Global economies and companies both feel the effects of a strong dollar through multiple channels. From a US perspective, the surge in the dollar makes goods priced in foreign currencies relatively cheaper, though the initial magnitude is likely to be small given the high share of US imports priced in dollars.
Dollar strength also impacts companies in the S&P 500 Index. Broadly speaking, roughly 40% of the index’s revenues come from foreign markets (Display). But in some sectors, like technology, the share is even higher. This year, with earnings from abroad worth less in dollar terms, foreign currency translation is having a larger impact on the earnings of US-based multinational companies. Even without further dollar strengthening, we expect those headwinds to adversely affect S&P 500 earnings growth in the first half of 2023.
The situation differs abroad. Overseas, an outsized (and stable) portion of cross-border trade is invoiced in dollars. This means that countries purchasing commodities and other goods on global markets with US dollars are paying more in their own currencies. Effectively, the US is exporting inflation. In turn, central banks with inflation mandates are responding with tighter monetary policy, weighing on global growth.
But some aren’t complaining. On the corporate side, companies with dollar-based earnings—such as European-headquartered global pharmaceutical companies—are benefiting from a relatively stronger dollar. And for investors in countries like the UK who have invested in the S&P 500, the decline in US stocks has been offset by the dollar’s appreciation.
Must All Things Come to an End?
What could end the dollar’s remarkable run? Some argue that dollar valuations appear stretched compared to recent history. After all, the dollar’s real effective exchange rate (REER)—which adjusts for differences in price level to capture how much any currency can actually buy—stands at a 22-year high (Display). An elevated REER indicates that the dollar remains strong in terms of its purchasing power.
Yet, a potentially expensive valuation alone does not imply an impending reversal. Valuation measures come in handy for anchoring to fundamentals. In practice, though, currencies often deviate substantially from “fair value” for extended periods.
Could a policy development prove to be a catalyst? It’s difficult to see the US mustering the political will to join a coordinated agreement, such as the Plaza Accord—an intervention in the mid-80s that intentionally weakened the US dollar. Such a move seems unlikely since the strong dollar aligns with keeping inflation in check, a key policy goal in DC at the moment.1 And unilateral intervention (which we’re currently seeing in Japan) is more likely to slow, rather than stop, the trend.
A fundamental catalyst prompting a reversal seems more plausible, with a shift in the Fed’s policy topping the list. The Fed has sent a strong message that interest rate hikes will continue until inflation is on a sustainable path lower. A successful battle against inflation could reverse any—or all—of the factors driving dollar strength laid out above. For instance, in the same way that widening interest rate differentials fueled the dollar’s appreciation, a pause in rate hikes could give other countries time to catch up. This would narrow (or at least maintain) nominal rate differentials, unwinding the effect we’ve seen this year.
Timing Is Tough
With so much uncertainty around inflation (and, therefore, the path of the dollar) in the near term, how should investors react? Trying to time a dollar reversal is fraught with risk. While there is a plausible path towards depreciation, the dollar rallied for good reason. Investors will be best served in the long run by maintaining balance. Incorporating non-US stocks into a long-term strategic allocation will provide exposure when the dollar eventually shifts gears. Until then, consider taking that trip to Europe.
- Roosevelt Bowman
- Senior Investment Strategist—Investment Strategy Team
- Maura Pape
- Senior Investment Strategist—Investment Strategy Team
1 The September 1985 agreement targeted US dollar depreciation relative to the Japanese, German, French, and UK currencies through currency intervention.